This Oil Market Can Make You Sick

Volatility is giving investors a severe case of seasickness-

The drop in crude oil prices so far in 2015 has been the steepest and quickest in modern history – or at least since the U.S. yielded its role as the global oil market’s swing producer. The futures’ price for West Texas Intermediate (WTI) on January 2 closed at $52.69 a barrel on its way to a near-term low of $44.45 on January 28. The nearly 16 percent drop was then wiped out by a four-day rally that shot prices up 19 percent, only to have them fall nine percent the following day. Welcome to Volatility 101! 

Through the first week of May, WTI has experienced seven double-digit percentage changes, both up and down, with an additional three moves that exceeded five percentage points each. While many believe oil prices have gone straight down since that fateful day in late November 2014 when OPEC confounded observers by holding its production quota stable and allowing market forces to set world oil prices, the oil market actually has experienced considerable volatility. In fact, there has been enough volatility to make market participants literally seasick. 

Motion sickness develops when the brain receives signals from the inner ear suggesting that it senses motion while the eyes tell the brain that everything is still. The brain concludes that the person is hallucinating and further believes that the hallucination is caused by ingesting poisons, which it then seeks to cleanse by causing the person to vomit. Unfortunately, the physical reaction to motion sickness does not resolve the issue, meaning the person may continue to vomit. 

The remedy is to get some fresh air and focus the eyes on the horizon in order to establish a measure of motion to match the motion signals being read by the inner ear. This advice may also prove appropriate for those actively watching or trying to divine the future of oil prices.

Volatility Drivers

After nearly four years of high and relatively stable oil prices, we appear to have entered a different environment in which volatility rules the market, fueled by the rapidly changing outlook for the multiple forces driving oil prices. Those forces are both large and small, ranging from weekly data points about current oil supply and demand and the drilling rig count to major trends such as new geopolitical alignments and regulatory restructurings of energy markets. 

The most recent move at the start of May was in response to a weekly data point – the announcement by the Energy Information Administration that, for the first time in 17 weeks, oil storage volumes in the U.S. had declined. Supplies fell by 3.9 million barrels, which was perceived as a positive for oil prices. However, the 487 million barrels still in storage marked the highest total ever for that corresponding week.

For those hoping for higher oil prices, the decline in weekly storage volumes suggests higher demand, which would be a plus as the industry expects lower production in response to the falling rig count. Unfortunately, oil import volumes were unusually low that week as well, confounding the analysis. While supply and demand remain the two most potent drivers for future oil prices, other factors might derail the current oil price recovery. 

The two most important forces that may impact future oil prices are the value of the U.S. dollar and the political situation in the Middle East. While others might point to increased pressure to restrict global carbon emissions or higher taxation and regulation of the petroleum industry as important factors, we consider them less likely to influence oil prices than the value of the U.S. dollar and the Middle East. 

The Fluctuating Dollar

The U.S. dollar has historically been an important factor influencing the direction of oil prices.  Oil is priced in dollars, and when the dollar strengthens the value of oil in dollar-terms declines.  Between 2003 and the spring of 2011, the dollar’s value steadily declined except for the violent moves associated with the 2008 financial crisis. During that turmoil, WTI had climbed from $28 to $110 a barrel with a brief excursion to $133 a barrel in mid-2008 before collapsing to $39 in February 2009. (We are using monthly averages rather than daily ones to match the U.S. dollar index data.)

From the 2009 low, WTI rose steadily to the modern high as global economic activity quickly recovered from the recession. The price climb required slightly over two years to reach its peak, but from that point forward WTI fluctuated between $100+ a barrel to lows in the $80s until the great collapse commenced in June 2014 when WTI was over $106 a barrel. What is important to note about the post-2008 recovery in WTI is that it was matched almost exactly by a retreat in the value of the U.S. dollar. 

The decline in the value of the dollar bottomed at almost exactly the same point that WTI reached its peak of $133 a barrel in June 2008 (see the accompanying chart). With the emergence of the 2008 financial crisis, it was only six months later that WTI hit bottom at $41 a barrel before starting its rebound that produced a four-year period of high oil prices.

Just as WTI plummeted by more than two-thirds during that 2008 period, the value of the U.S. dollar climbed from -1.4 to positive 0.7, a significant move. At the same time oil prices began recovering, the value of the U.S. dollar started to decline. Both measures reached their respective peaks and valleys at the same point in time, just as they had in mid-2008. 

When we shift our focus to the most recent oil price collapse, June 2014 marked the peak in oil prices at slightly over $105 a barrel while the U.S. dollar value index was at a low of -0.5.  By January 2015, oil prices had dropped by more than 50 percent to a low of $47 a barrel while the U.S. dollar value index reached 1.8. Over the next two months oil prices rallied as the dollar weakened, but then the value of the dollar rose again and oil prices, having bounced up to $51, fell back to $48 a barrel as the U.S. dollar value index climbed to 2.2. As the dollar index retreated by 0.5 to 1.7 in early May, WTI rallied back to $60 a barrel. 

Despite the fluctuations in the dollar index, it appears that the stronger growth of the U.S. economy and the prospect that the Federal Reserve will soon be raising domestic interest rates are magnets for international capital to flow into the U.S. and further strengthen the dollar.  Based on this driver alone, the oil industry should be preparing for an extended period of lower oil prices, or maybe an extended period of oil trading in a wide range of $40-$60 a barrel, unless the other major driver of global oil prices – Middle East geopolitics – changes. 

Middle East Geopolitics

The proxy wars being waged by the two economic and religious powers in the region, Iran and Saudi Arabia, have added a new dynamic to the pricing of oil, and that is the risk premium assigned to the potential loss of significant amounts of world oil supplies.  

The recent revamping of the Saudi Royal Family’s leadership and line of succession appears to have been driven by King Salman’s view that Iran and terrorism are his country’s primary threats and that these threats will last longer than generally believed just a short while ago. The potential for a U.S.-Iran nuclear treaty that may temporarily delay when Iran might be able to build a nuclear weapon could set off an arms race throughout the Middle East with Saudi Arabia as the most likely next country to join the planet’s nuclear club. 

At the same time, a nuclear treaty could reopen the doors for Iran to step up its oil output along with welcoming in western oil companies eager to secure access to the country’s large reserves. The prospect of additional oil supplies reaching the global market could exert additional downward pressure on oil prices, at least until low oil prices significantly curtail other supply sources and boost global economic growth. 

The prospect of an unshackled Iran may force Saudi Arabia to continue to decline its historic role of swing oil producer, thereby keeping prices lower and more volatile than they might otherwise be. Speculation last November was that OPEC’s decision to let market forces determine global oil prices was really a war against the U.S. shale oil industry. But there is little to support that view as the shale business is driven by many small companies and not the industry’s largest producers. 

Oil price volatility is now the rule rather than the exception. Grab your Dramamine and enjoy the ride! – MarEx